The Deterrent Effect of Whistleblowing on Insider Trading

Abstract

An objective of the Dodd-Frank Act was to improve the detection of financial fraud, including insider trading, through the creation of the whistle-blower bounty program at the SEC. This program provides for substantial financial rewards and strong anti-retaliation provisions to protect whistle-blowers. I test the effectiveness of the whistle-blower program in reducing informed trading by corporate insiders. I isolate the effect of the program from that of other concurrent reforms by identifying insiders of firms that are more sensitive to whistle-blowing allegations. For a sample of firms that lobbied against the whistle-blower provisions of the Act, I find that the profitability of insider purchases significantly reduces post Dodd-Frank relative to that of other insiders. The reduction in abnormal profits is economically meaningful, in the range of 0.05% to 0.10% daily return. I find similar results for insiders of firms with weak internal whistle-blower programs who are likely to be more sensitive to the new regulation, and for insiders of firms perceived by market participants as benefiting from the additional oversight provided by the program. I analyze whether the whistle-blower program was effective in reducing informed insider sales by examining pre-earnings announcement and pre-M&A settings when insider transactions are more likely to be information-driven. I find that, post Dodd-Frank, insiders are less likely to sell before events that are perceived negatively by investors. The legal literature suggests that insider trading behavior is more difficult to expose and prove than corporate-level fraud. In contrast with the beliefs of the program critics, I find that whistle-blowers are effective deterrents of insider trading, suggesting that they are a valuable resource for unravelling this hard-to-detect illegal activity.